Limits of arbitrage: the state of the theory

Denis Gromb and Dimitri Vayanos

LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library

Abstract: We survey theoretical developments in the literature on the limits of arbitrage. This literature investigates how costs faced by arbitrageurs can prevent them from eliminating mispricings and providing liquidity to other investors. Research in this area is currently evolving into a broader agenda emphasizing the role of financial institutions and agency frictions for asset prices. This research has the potential to explain so-called "market anomalies" and inform welfare and policy debates about asset markets. We begin with examples of demand shocks that generate mispricings, arguing that they can stem from behavioral or from institutional considerations. We next survey, and nest within a simple model, the following costs faced by arbitrageurs: (i) risk, both fundamental and non-fundamental, (ii) short-selling costs, (iii) leverage and margin constraints, and (iv) constraints on equity capital. We finally discuss implications for welfare and policy, and suggest directions for future research.

Keywords: limits of arbitrage; market anomalies; liquidity; financial constraints; financial institutions; survey (search for similar items in EconPapers)
JEL-codes: D60 D80 G10 G20 (search for similar items in EconPapers)
Pages: 33 pages
Date: 2010-04-16
References: Add references at CitEc
Citations: View citations in EconPapers (22)

Downloads: (external link)
http://eprints.lse.ac.uk/119089/ Open access version. (application/pdf)

Related works:
Working Paper: Limits of Arbitrage: The State of the Theory (2010)
Working Paper: Limits of Arbitrage: The State of the Theory (2010)
Working Paper: Limits of Arbitrage: The State of the Theory (2010)
This item may be available elsewhere in EconPapers: Search for items with the same title.

Export reference: BibTeX RIS (EndNote, ProCite, RefMan) HTML/Text

Persistent link: https://EconPapers.repec.org/RePEc:ehl:lserod:119089

Access Statistics for this paper

More papers in LSE Research Online Documents on Economics from London School of Economics and Political Science, LSE Library LSE Library Portugal Street London, WC2A 2HD, U.K.. Contact information at EDIRC.
Bibliographic data for series maintained by LSERO Manager ().